FINANCIAL INSTRUMENTS AND LEGAL FRAMEWORKS OF DERIVATIVES MARKETS IN EU AGRICULTURE: CURRENT STATE OF PLAY AND FUTURE PERSPECTIVES

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3 DIRECTORATE-GENERAL FOR INTERNAL POLICIES POLICY DEPARTMENT B: STRUCTURAL AND COHESION POLICIES AGRICULTURE AND RURAL DEVELOPMENT FINANCIAL INSTRUMENTS AND LEGAL FRAMEWORKS OF DERIVATIVES MARKETS IN EU AGRICULTURE: CURRENT STATE OF PLAY AND FUTURE PERSPECTIVES STUDY

4 This document was requested by the European Parliament's Committee on Agriculture and Rural Development. AUTHORS 1 SOMO, the Netherlands: Myriam VANDER STICHELE RESPONSIBLE ADMINISTRATOR Albert MASSOT Policy Department B: Structural and Cohesion Policies European Parliament B-1047 Brussels EDITORIAL ASSISTANCE Catherine MORVAN LINGUISTIC VERSIONS Original: EN ABOUT THE PUBLISHER To contact the Policy Department B or to subscribe to its monthly newsletter please write to: Manuscript completed in July Brussels European Union, This document is available on the Internet at: DISCLAIMER The opinions expressed in this document are the sole responsibility of the authors and do not necessarily represent the official position of the European Parliament. Reproduction and translation for non-commercial purposes are authorized, provided the source is acknowledged and the publisher is given prior notice and sent a copy. 1 Contributors: Ann E. BERG (Senior consultant at the United Nations, Food and Agricultural Organization - FAO); Jaap BOS (Maastricht University, the Netherlands); Benoît LALLEMAND (Finance Watch); David FRENK (Better Markets); Indra RÖMGENS (SOMO, the Netherlands), Rens VAN TILBURG (SOMO, the Netherlands). Advisors: Daniël MÜGGE (University of Amsterdam, the Netherlands). Peer Review: Patrick STEPHAN (FOM University of Applied Sciences, Germany). Editor: Gioia Marini.

5 DIRECTORATE-GENERAL FOR INTERNAL POLICIES POLICY DEPARTMENT B: STRUCTURAL AND COHESION POLICIES AGRICULTURE AND RURAL DEVELOPMENT FINANCIAL INSTRUMENTS AND LEGAL FRAMEWORKS OF DERIVATIVES MARKETS IN EU AGRICULTURE: CURRENT STATE OF PLAY AND FUTURE PERSPECTIVES STUDY Abstract For the first time, new EU laws regulate the agricultural commodity derivatives markets and their participants. By 1 st July 2014, some important technical standards and other instruments that determine the effectiveness and the enforcement of these laws still needed to be decided. This study finds that the price discovery and hedging functions of European agricultural commodity derivatives markets and their related infrastructure in the physical agricultural markets need improvements from the perspective of European farmers and the agricultural sector. IP/B/AGRI/IC/2013_142 July 2014 PE EN

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7 Financial instruments and legal frameworks of derivatives markets in EU agriculture CONTENTS LIST OF ABBREVIATIONS 5 LIST OF TABLES 7 LIST OF FIGURES 7 GLOSSARY 9 EXECUTIVE SUMMARY 15 1 HOW AGRICULTURAL COMMODITY DERIVATIVES MARKETS AND SPOT MARKETS FUNCTION Introduction Market-oriented CAP reform and producers risk management tools Current landscape of agricultural derivatives markets Overview of the existing literature Concluding overview: background for EU regulation 37 2 STATE OF PLAY OF EU AGRICULTURAL REGULATION AND ITS COMPARISON WITH OTHER LEGAL FRAMEWORKS Introduction Crucial parts of EU laws regulating commodity derivatives markets Comparing EU regulation: main elements of importance to agricultural commodity derivatives 58 3 ASSESSMENT OF EU COMMODITY DERIVATIVES REGULATION AND ACCOMPANYING RECOMMENDATIONS Assessment of the current state of EU legislation: objectives and principles Assessing the effectiveness of key instruments in current EU legislation 73 4 MISSING INSTRUMENTS AND NEW CHALLENGES Missing instruments New challenges Challenges arising from the international regulatory landscape 98 REFERENCES 101 ANNEX: Technical overview COMPARING EU AND US LEGISLATION on commodity derivatives 105 3

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9 Financial instruments and legal frameworks of derivatives markets in EU agriculture LIST OF ABBREVIATIONS AIFs Alternative Investment Funds AIFMD Alternative Investment Fund Managers Directive AMIS Agriculture Market Information System BCBS Basel Committee on Banking Supervision CAP Common Agricultural Policy CCP Central Counterparty CFTC Commodity Futures Trading Commission COMAGRI Agricultural and Rural Development Committee CRD & CRR Capital Requirements Directive & Capital Requirements Regulation EC European Commission ECB European Central Bank EMIR European Market Infrastructure Regulation EP European Parliament ESCB European System of Central Banks ESMA European Securities and Markets Authority ESRB European Systemic Risk Board ETFs Exchange Traded Funds ETNs Exchange Traded Notes ETPs Exchange Traded Products FSB Financial Stability Board FAO Food and Agricultural Organisation of the UN HFT High Frequency Trading IMF International Monetary Fund IOSCO International Organisation of Securities Commissions MAD Market Abuse Directive MIFID Markets in Financial Instruments Directive MiFIR Markets in Financial Instruments Regulation 5

10 Policy Department B: Structural and Cohesion Policies MTF Multilateral Trading Facility OECD Organisation of Economic Cooperation and Development OJ Official Journal of the European Union OTC Over-the-counter, off exchange OTF Organised Trading Facility POs Producer Organisations PRIP Packaged Retail Investment Product SEF Swap Execution Facility UCITS Undertaking for Collective Investment in Transferable Securities UNCTAD United Nations Conference on Trade and Development WFP World Food Programme WTO World Trade Organisation WTO World Trade Organisation 6

11 Financial instruments and legal frameworks of derivatives markets in EU agriculture LIST OF TABLES TABLE 1 Different participants in agricultural commodity derivatives markets 39 TABLE 2 EU laws covering trading and participants on agricultural derivatives markets 42 TABLE 3 Participants of derivatives markets regulated by EU laws 64 LIST OF FIGURES FIGURE 1 Trading volumes in agricultural futures contracts at the CME ( ) 27 FIGURE 2 Evolution of global commodity ETP assets under management ( ) 28 FIGURE 3 CFTC Commitment of Traders (May 2013-May 2014) 30 7

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13 Financial instruments and legal frameworks of derivatives markets in EU agriculture GLOSSARY Algorithmic trading Alternative investment funds (AIFs) Arbitrage Asset Basis Bid price Block trading Broker Capital requirements Cash settlement Central counterparty (CCP) Circuit breaker Clearing Clearing house Collective investment schemes A trading system that utilizes very advanced (computerised) mathematical models ('algorithms') in order to make optimal transaction decisions in the financial markets, (mostly) without human intervention. All funds that are under EU law not regulated by UCITS Directives (see UCITS), such as hedge funds and private equity funds. Buying and selling of a same asset (e.g. a commodity, a financial instrument) that is being traded in two or more different markets in order to profit from price differences. Anything with a commercial or exchange value and owned by a business, institution or individual. The price difference between a spot contract and futures contract for a commodity. The highest price which a buyer is willing to pay for a commodity or security. Buying or selling very large numbers of securities, mostly outside exchanges or electronic markets in order to avoid too much undesired impact on the price. An individual or firm who is an intermediary between a buyer and a seller, and charges a fee or commission for executing buy and sell orders. Regulations that set criteria for the minimum own capital a bank, or other financial institution, has to hold when granting loans or undertaking other financial activities. A way of settling a futures contract which involves an exchange of cash rather than an exchange of a physical commodity, e.g. when a buyer is not interested in taking a delivery. An entity that interposes itself between the counterparties to a derivatives contract, becoming the buyer to every seller and the seller to every buyer. If one of the counterparties defaults, the CCP absorbs the loss and pays the other counter party. Mechanism employed by an exchange to temporarily suspend trading when prices fall, or increase, beyond a pre-set percentage in a specified period (in order to prevent mass panic selling or buying). Process by which risks and obligations arising from a derivative or other financial security are managed over the lifetime of a financial contract by a CCP or clearing house. An entity that becomes the counter party to the buyer and the seller of a derivatives contract. It reduces counterparty risk by absorbing losses (see CCP) and ensures that futures contracts are fulfilled, including that the underlying commodities are actually delivered. Funds that pool together many different individuals savings and then invest them collectively. For example, commodity index funds or exchange-traded funds (ETFs) are all examples of collective investment schemes. 9

14 Policy Department B: Structural and Cohesion Policies Commodity Commodity derivative Commodity exchange A physical substance, such as food, grains, and metals, which are traded on the spot market and on physical commodity exchanges. A financial instrument the value of which is related to that of a commodity. One of the most important types of a commodity derivative is a futures contract traded on an exchange. A central market place, being a (for-profit) entity that determines and enforces rules and procedures for the trading of commodity derivatives. In this study it does not refer to the physical centre where trading takes place. Commodity index A price indicator, or benchmark, that reflects the price of a commodity future, or a composition ('basket') of commodity futures which are traded on exchanges. The price is regularly determined by the application of a formula on the basis of the value of the underlying commodity derivatives. Commodity index fund Convergence Cornering A fund for (institutional) investors who get a return on their investment based on the performance, i.e. the value, of the commodity index that the fund is tracking. The tendency for prices in spot markets to be similar as futures prices when the delivery dates of the futures contract approach. To corner a commodity market is to get sufficient control of trade in a commodity to allow the price to be manipulated. Counterparty Dealer Delivery Depositories Derivative Electronic trading facility Exchange traded commodity (index) fund (ETF) Exchange traded note (ETN) Exchange traded products (ETPs) Financial counterparties A legal term for the other party in a financial transaction. For a buyer of a derivatives contract, the seller is the counterparty and vice versa. An individual or firm that buys and sells securities for his/her own account and own risk. Receiving the actual commodity or warehouse receipts covering such commodity at the time of the settlement of a futures contract. Entities that are entrusted with the duty of safekeeping and supervision of the assets belonging to a fund or financial entity. A financial contract that gets (derives) its value from an underlying asset, such as foreign currencies, interest rates or commodities. A trading venue which operates solely via telecommunication, internet or electronics rather than floor trading where traders see each other. The value of the ETF and its shares, which are sold on a (specialised) stock exchange, is related to the value of a commodity index that it tracks, a commodity or a basket of commodities. A synthetic ETF bases its value on an commodity index or commodities but the money invested in that fund is not used to buy the named assets but is used to buy (or to swap with) other assets. An unsecured debt obligation issued by a bank who promises to pay at a pre-determined date the amount reflecting the value of the underlying asset or index. Reference to ETFs, ETNs and other financial instruments or funds whose shares are sold on exchanges. Financial entities trading in derivatives, including investment firms, banks, providers of investment products (such as commodity index ETFs), pension funds and hedge funds. 10

15 Financial instruments and legal frameworks of derivatives markets in EU agriculture Forward (contract) Fundamentals Futures Hedge funds (Bona-fide) hedging High frequency trading (HFT) A contractual agreement, not traded on an exchange, between two parties to buy or to sell a specific quantity of a commodity, or other asset, at a specified future time at a price agreed upon today. Information and data on the supply and demand of goods and services in the real economy. Standardized contractual agreements to buy or sell a fixed quantity of a particular commodity, a currency, bond or stock at a pre-determined price in the future. The contract can be physically settled (through delivery of the underlying) or cash settled. Specialist investment funds for institutional investors, using speculative strategies and leverage to obtain the highest possible return on their investments in the short term. Selling or buying commodity derivatives contracts to manage risks of price changes in the commodities directly related of a firm's core business (definition for this study). A type of extremely fast electronic trading based on algorithms using advanced computer systems, which is characterised by holding positions very briefly (micro-seconds) in order to take advantage of opportunities small price rises and falls. Intra-day trading Taking positions several times a day to capitalize on price movement within one trading day and by closing all trades before the end of the trading day. Insider dealing Level 2' decision making (technical regulation) Leverage Liquid Market Liquidity Trading on the basis of non-public information (not available to other traders) to make a profit. Decision-making in the EU, after a law has passed, on the (regulatory or implementing) technical standards, EC delegated acts, or guidelines and recommendations issued by the European regulators or supervisory authorities. Leverage is the use of borrowed funds that are (re)invested with the intent to earn a greater rate of return from an investment. Any market where buying and selling can be easily conducted with minimal effect on the price or where large number of buyers and sellers are present offering and willing to buy for instance a same commodity. Liquidity is a complex concept reflecting how easy or difficult it is to buy or sell a particular asset, e.g. the same commodity derivative, without affecting the price significantly. Long position ('long') Margin Market integrity Market maker The party holding a contract agreeing to buy the underlying asset, such as a quantity of a commodity, in the future, or to settle in cash. Collateral or deposit (of cash or eligible securities) that counterparties who are clearing are required to provide to the CCP or clearing house, and which can change daily according to the risks of default and changing value of the contract being cleared. Market integrity is the fair and safe operation of markets, without misleading information, manipulated prices or insider trades, so that hedgers and investors have confidence and are sufficiently protected. A trader/company which ensures liquidity for other market participants by standing ready to buy or sell at publicly quoted bid and offer prices for a same security throughout the trading session. 11

16 Policy Department B: Structural and Cohesion Policies Multilateral trading facility (MTF) Netting Net position Non-financial counterparties Open interest Open position Option Organised trading facility (OTF) Over-the-counter (OTC) Position limit Position management Post-trade transparency Pre-trade transparency Price discovery Regulatory arbitrage Retail investor Securities Securitisation Settlement A trading venue or system operated by investment firms or market operators, which brings together multiple third-party buying and selling interests in financial instruments, including commodity derivatives, in a way that results in a contract. Offsetting the value of multiple positions, one against a similar one. The difference between 'long' and 'short' market positions held by an individual or a company, after netting. Entities holding commodity derivatives contracts, whose main business is producing, storing, trading and processing commodities. The total number of active or outstanding contracts in a futures or options market. Holding a derivatives contract that is not yet closed. A derivative contract offering the buyer the right, but not the obligation, to buy or sell a security or financial asset at an agreed-upon price during a certain period of time or on a specific date. A facility or system operated by an investment firm or a market operator that on an organised basis brings together third party buying and selling interests or orders relating to financial instruments, not being a MTF. Trading that does not take place on an exchange, other regulated market or trading venue, and can take various forms such as direct bilateral trading or a bilateral contract between a bank and a customer. A pre-set limit defining the maximum number, or value, of derivatives contracts a (legal) person, or a class of traders, can hold in one particular underlying security at a particular moment. Monitoring the positions held by different entities, including to ensure that position limits are adhered to, and potentially intervening when disorderly trading occurs. Public trade reporting every time a transaction of a security has been concluded. Publication (in real-time) of information about current orders and quotes (i.e. prices and amounts of selling and buying interests) relating to securities' trade. Mechanism of price formation on a market, based on the activity of buyers and sellers actually agreeing on prices for transactions. Practice whereby firms use loopholes in regulatory systems or differences between different jurisdictions in order to circumvent unfavourable regulation. A person investing his own money on a non-professional basis. All kinds of tradable assets, financial instruments or electronic book entries, negotiable instruments or certificates, which entitle the holder to rights transferred by the issuer or an intermediary, such as shares, derivatives, and bonds. The process of transforming an illiquid asset, or group of assets e.g. financial contracts, into a (tradable) security through financial engineering. The completion of a transaction, discharging participants obligations through the transfer of money and/or securities and/or commodities. 12

17 Financial instruments and legal frameworks of derivatives markets in EU agriculture Short position Speculator Spot market Spot month Spot price Systematic internaliser Swap Swap execution facility (SEF) Tick size Trade repository Trading book Trading platform Trading venue Treasury financing activities Undertakings for collective investment in transferable securities (UCITS) Underlying Volatility Volume of trade A counterparty holding a derivatives contract agreeing to sell the asset in the future. A trader who does not take a bona fide hedging position in the market with the intention of making profits. A market in which physical commodities are bought and sold for cash and immediate delivery. Also called cash market or physical market. Month in which a commodity derivative contract expires and delivery of a physically settled commodity derivative takes place at the end of the contract, or cash is paid in accordance with the terms of the contract. The marketplace price for the physical commodity, also referred to as cash price. Investment firm or other financial firm that matches client orders internally, or against their own books on an organised and systematic basis, outside a regulated trading venue. A derivative that involves an exchange of payment flows over a specified period for a specified quantity based on a particular reference price. In the US, 'swaps' are all derivatives traded OTC. A trading system open to multiple participants through which multiple participants trade swaps. The smallest possible change in price for a financial instrument in a market. An entity that centrally collects and maintains the records of trading in financial contracts, storing the essential characteristics of those contracts for future reference. All the financial instruments held by a brokerage or a bank with the intention of re-selling them in the short term, to serve clients, to hedge other instruments in the trading book or to make profits. The software or computer system, frequently offered by brokers, through which trading orders for financial products can be placed. A regulated venue where securities are exchanged, including exchanges, MTFs and OTFs. Management of financial flows and financial/bank relationships of a firm, which may include trading in currencies and financial derivatives for financial risk management. A standardised and regulated type of asset pooling, often an investment fund, subject to harmonised EU rules and typically devised for, and marketed to, retail investors. The stock, commodity, futures contract, or index against which a derivatives contract is valued. The rises and falls in value, or the general fluctuation of prices or markets in a period of time, usually expressed as a percentage. The number of contracts traded during a specified period of time. 13

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19 Financial instruments and legal frameworks of derivatives markets in EU agriculture EXECUTIVE SUMMARY The reforms of the financial markets following the financial crisis of 2008 resulted for the first time in a common EU regulatory and supervisory framework for agricultural commodity derivatives. The aim of this study is, firstly, to assess the current state 2 of the EU legislative framework regulating agricultural commodity derivatives markets from the perspective of EU farmers and the EU agricultural sector. Special attention is paid to the integrity of the key functions of trading in agricultural commodity derivatives, namely managing the risks of price changes ( bona fide hedging ) and indicating agricultural prices ( price discovery ). The second aim of this study is to make concrete recommendations based on assessments of the legislative framework in general as well as specificities in the relevant laws. This study concludes that the perspective of EU farmers and the food chain has not been explicitly taken into consideration in the new legislative framework, even if farmers may in general benefit from more regulations in the commodity derivatives markets. Since few of the new rules on derivatives protect the specific interests of EU agricultural markets and EU farmers, this study finds many opportunities to further improve the technical standards, rules, regulations and supervision governing European agricultural derivatives traded both on exchanges and over the counter (OTC), as well as the related infrastructure and supervision of the physical agricultural markets. The first section of this study describes how agricultural commodity derivatives markets work and how different traders operate, how the common agricultural policy relates to them, and how they are analysed in the academic literature. The second section briefly describes eleven of the most recent EU laws that regulate different aspects of agricultural commodity derivatives and the various participants in these derivatives markets. The EU regulatory framework is then compared with that of the US and India. Section 3 is the most important section in this study and assesses in detail various aspects of the regulatory framework. It provides concrete recommendations to improve the standards, regulations, supervision as well as the working of agricultural derivatives markets for farmers. Section 4 highlights the elements that are missing in this regulatory framework for a comprehensive agricultural commodity derivatives policy. This study starts by describing how the EU common agricultural policy (CAP) is becoming more market-oriented, which in turn is resulting in more volatility in agricultural prices. The latest CAP reform has, however, not included agricultural commodity derivatives as risk management instruments and therefore not built the capacity to do so. In addition, the new financial markets reform did nothing to ensure that the infrastructure for hedging price risks through derivatives markets is well-suited to the EU's agricultural spot markets. This is because the EU financial legislation as well as the EU CAP reforms have not taken into consideration those farmers interested in hedging through derivatives. Similarly, little attention has been paid to whether the format of agricultural commodity derivatives contracts fits the needs of agricultural farmers in the EU. This contrasts with the instruments available to US farmers, who use futures and options for bona-fide hedging much more intensively than EU farmers, who tend to be much smaller and rely much more on cooperatives and off-exchange (OTC) derivatives to manage price risk. 2 By 1 st of July

20 Policy Department B: Structural and Cohesion Policies Commodity derivatives markets have changed dramatically since 2000, largely due to the growing participation of new financial parties such as investment banks, hedge funds, pension funds and providers of commodity (index) investment products. The spike in food prices in , and the more general increase in volatility of agricultural commodity derivatives prices since then, have given rise to much political discussion and have spawned a range of academic studies on commodity derivatives markets. Although there still is no clear consensus among academics on the extent to which financial participants affect commodity derivatives markets and spot market price volatility, the EU has decided to adhere to G20 policy orientations to improve the functioning of these markets, and to limit the influence and size of financial participants in commodity trading both on and off exchanges, and to reduce the risks posed by various financial and speculative actors in the commodity derivatives markets. This has resulted in a series of new EU laws (see Table 2 of this study), which this study assesses. Despite the best of intentions, however, these EU laws will enter into force much later than the scheduled implementation of the G20 reform agenda and moreover fall short of comprehensively applying some of the principles agreed upon. The EU laws aim to protect the integrity, efficiency and transparency of commodity derivatives markets in general. To this end, these laws could significantly reduce: the risks of defaults (through clearing ), the lack of information, the disorderly functioning of commodity derivatives markets, resulting financial instability, the excessive influence of financial participants, market manipulation and conflicts of interest. The most significant EU instruments regulating the commodity derivatives markets, including agricultural derivatives trade, are: the obligation to clear all derivatives traded on exchange and designated derivatives off exchange, the obligation to report all OTC derivatives, the obligation to trade particular, especially standardised, OTC derivatives on exchanges or other regulated trading venues ( trading obligation ), limits to the amount of commodity derivatives contracts a participant can hold for non-hedging purposes, through a quantitative threshold ( position limits ), risk-mitigating requirements for trading venues, clearing houses and tradereporting entities. In addition, the powers given to the competent authorities to regulate and intervene against market abuse aim to protect spot agricultural markets from abusive practices on derivatives market and vice versa. Importantly, to deal with new developments, high frequency trading ( HFT ) will be restricted to a certain extent, although instruments for close supervision are lacking. Regarding the direct regulation of the different financial participants (see Table 1 of this study), most have been subject to stricter risk-mitigation requirements (e.g. banks that trade in agricultural commodity derivatives). Managers of commodity index funds, which have been very active on US commodity derivatives exchanges, have been forbidden in the EU to directly hold any commodity derivatives. In contrast, the EU has introduced for the first time legislation directed at some of the most speculative financial participants in the agricultural commodity derivatives markets hedge funds but authorities have little means to intervene in their activities related to agricultural commodity derivatives markets. The different EU laws contain some significant loopholes. For instance, the limits on speculative positions held by financial participants are not imposed on a whole class of 16

21 Financial instruments and legal frameworks of derivatives markets in EU agriculture speculative traders. Position limits will be imposed on a netted position, which means that (agricultural) commodity contracts held by a financial participant can be much higher than the position on which his position limits is imposed, while risks from different counterparties (e.g. different clearing houses) might remain. There is little regulation on how trading venues will monitor whether or not positions are for bona fide hedging, with HFT traders likely to evade the rules. Other potential loopholes are the exemptions from the clearing and trading obligation for ancillary activities or intra-group activities. In practice, there is no guarantee that the clearing and trading obligation of OTC commodity derivatives will significantly reduce the less regulated OTC agricultural commodity derivatives traded by financial participants. It will be some years before reports with aggregate data on (agricultural) commodity trade on EU trading venues become publicly available, in contrast to the US where such reports have been published on a weekly basis already for decades. This study found that there will be a lack of publicly available information about OTC agricultural derivatives trading, which are relatively extensively used by EU farmers and other users in food chain. Note that transparency is an important prerequisite for the efficient implementation, supervision and enforcement of the EU legislation. Transparency also provides farmers, parliamentarians and other policymakers, scientific researchers and other stakeholders with better data. The lack of real-time and detailed reporting to supervisors on trading in agricultural commodity derivatives prevents them from intervening swiftly in disorderly functioning markets, such as those caused by HFT trading. Common EU supervisory measures and intervention powers for authorities have been introduced, but they will be implemented mainly at the national level, which has its strengths and weaknesses. In some of the financial laws covered in this study, the degree of coordination among national supervisors as well as supervision at the EU level by ESMA are weak, especially in the EU law on hedge funds (AIFMD). The cooperation of financial supervisors with national or EU authorities and public bodies from the agricultural sector in the areas of information sharing and joint supervisory and enforcement activities on agricultural commodity derivatives markets are not specific enough or even deficient in some new laws. For example, access to OTC agricultural derivatives trade data by agricultural authorities is not foreseen (EMIR). This study recommends that agricultural authorities increase their capacity to monitor agricultural spot and financial markets as well as hedging and speculative trading by agribusinesses in commodity derivatives so as to build up their capacity for supervision jointly with financial supervisors of both physical and financial agricultural markets. Doubts remain as to whether supervisory bodies have the capacity, the expertise, the financial and technological resources, or even the willingness to supervise and enforce the many new rules being introduced. Important arrangements still have to be agreed upon regarding how to deal with providers, operators and traders from third countries. Such agreements have proven to be a politically difficult exercise, despite the fact that commodity derivatives trade has become very much an international business, particularly across the Atlantic. The EU s framework to regulate and supervise the agricultural commodity derivatives markets was far from finalised by 1 st of July 2014 (end date of this study). How the strengths and weaknesses of many of the EU laws will be amplified or reduced are to be decided upon in the period (or later). Indeed, many significant technical standards still need to be set by regulatory bodies (especially ESMA and the European Commission) regarding definitions, exemptions, operational requirements, agreements between competent authorities in the EU and third countries, and agreements between ESMA and national competent authorities. In order to ensure that the perspective of 17

22 Policy Department B: Structural and Cohesion Policies European farmers is taken into consideration, the European Parliament's Committee on Agriculture and Rural Development (COMAGRI) should voice its opinions on the technical standards while they are being decided upon. Once developed (draft) technical standards are submitted to the European Parliament (EP) before their adoption, the COMAGRI should find ways to assess how the interests of the agricultural sector and farmers have sufficiently be taken into account. This study also recommends that agricultural EU and national policymakers, COMAGRI, farmers organisations and agricultural experts make their own assessments of the implementation of the current legislation, and take measures to fill the gaps (e.g. the detailed reporting of agricultural commodity derivatives; defining the list of agricultural derivatives in the EU, the agricultural derivatives contract formats and related delivery points). Once the overall regulatory and supervisory framework is clear, farmers can judge whether or not agricultural commodity derivatives markets are useful price risk management tools adapted to their specific needs, and whether or not they are effective market price benchmarks that are protected against manipulation. The final remarks and recommendations (Section 5) highlight in short what is missing for a comprehensive commodity derivative legislation and agricultural price risk mitigation policy. Different problems of connecting the agricultural spot markets and derivatives markets have to be solved. Financial and commercial market participants sometimes react to changes in commodity prices with risky new strategies that not only affect the commodity derivatives but also other financial or physical markets. Supervisors and regulators should have sufficient capacity and powers to deal with new financial products and trading practices that are risky and destabilising. Upcoming EU regulatory developments and new negotiations on liberalising trade and investment in financial services should be accompanied by initiatives that prevent them from undermining or contradicting the financial reforms that protect the hedging and price discovery functions of agricultural commodity derivatives markets. Scope of the study According to its terms of reference, this study has used a multidisciplinary approach focused on regulatory regimes of agricultural derivatives markets regarding hedging potential and price formation in the context of the ongoing liberalisation of agriculture. The guidance offered to the EP from this study is therefore based on: (1) the policy goals as embraced by the EU laws, (2) what we know from scholarly research about the functioning of agricultural derivatives markets, (3) an appraisal of existing relevant regulation in the field, and (4) an analysis of how well this legislation enables EU farmers to use agricultural derivatives markets for their price risk management and price formation needs. This study did not look into the particular details and specific regulations (and exemptions) in the described EU laws relating to energy commodity derivatives markets. However, these are of particular importance to farmers because: Energy prices, and thus orderly pricing mechanisms, are important for the prices farmers pay for their energy, fertilizer and transport needs (input prices). Commodity index funds must be based on mixed commodity indexes in order to be accepted as EU-regulated commodity investment funds (UCITS IV). If energy prices are volatile or unduly increasing, this influences the composition of the whole index and, in the EU mixed index system, can lead to indirect non-hedging buying of agricultural futures through swaps. This can influence the functioning and orderly pricing of agricultural commodity derivatives exchanges. 18

23 Financial instruments and legal frameworks of derivatives markets in EU agriculture It was not within this study's terms of reference to assess the potential socio-economic impact, in particular on rural areas, of the use of agricultural commodity derivatives in the context of more intense competition among farmers following the liberalisation of the agricultural market. Questions can be asked about the relationship between the use of these derivatives, the incentive structures they generate for farmers, and other goals of agricultural policy, including environmental sustainability and food security. 19

24 Policy Department B: Structural and Cohesion Policies 20

25 Financial instruments and legal frameworks of derivatives markets in EU agriculture 1 HOW AGRICULTURAL COMMODITY DERIVATIVES MARKETS AND SPOT MARKETS FUNCTION KEY FINDINGS Commodity derivatives markets are used by farmers to manage the risk of an adverse change in prices ( hedging ). They also function as an important instrument for price indication ( price discovery ). The increased use of commodity futures by financial parties and the growth of off-exchange agricultural derivatives over the last ten years have dramatically altered both speculative and hedging transactions in the agricultural derivatives market. The financial parties represent a range of actors with different behaviour patterns and profit-making strategies. Large differences exist between EU and the US agricultural commodity derivatives markets. US farmers use futures and options markets much more intensively than EU farmers, who tend to be much smaller and rely much more on cooperatives and off-exchange derivatives to manage price risk. A survey of the existing peer-reviewed literature reveals three different views on the functioning and impact of commodity derivatives markets. The first view holds that developments in futures markets have no impact on spot prices and their volatility. According to the second view, developments in futures markets do affect spot prices, but these effects are short-lived. And the third view argues that developments in futures markets and distortions caused by financial players directly affect the volatility and levels of spot prices. 1.1 Introduction Commodity derivatives markets are unique mechanisms. Unlike securities markets, which provide a forum for raising capital, commodity derivatives markets provide instruments for transferring the risk of price changes of an underlying commodity (this is referred to as hedging ). This allows farmers to lock in a harvest price. In addition, the buying and selling on exchanges of derivatives contracts namely futures and options help to determine the spot prices of commodities and therefore perform the valuable function of price discovery. Over the last ten years, there has been a drastic increase in speculative flows in agricultural derivatives markets. This increase in speculation can be attributed to a number of factors: the growth in the US of off-exchange agricultural derivatives (also known as over-thecounter or OTC derivatives), the accelerating trend towards financialisation of commodity futures trading (i.e. the increasing dominance of financial participants with no motives related to producing, trading or selling physical agricultural commodities), the incorporation of futures in commodity investment products ( securitisation ), the increasing presence of commodity hedge funds, and the entry of banks into the commodity space. These developments have compounded the difficulty of creating a comprehensive and consistent regulatory framework that preserves the primary functions of price discovery and risk 21

26 Policy Department B: Structural and Cohesion Policies transfer for those for whom the exchanges were originally intended, i.e., those involved in the production, storage, distribution, and processing of basic agricultural goods. 1.2 Market-oriented CAP reform and producers risk management tools Under the former Common Agricultural Policy (CAP), agricultural prices were set by the EU, which required excess production to be bought up and stored. This system of intervention worked as follows: EU farmers would sell their products at harvest time to local cooperatives or producer organisations (POs) that were approved by EU intervention agencies to tender their stocks to be bought up. 3 As the CAP policy was gradually liberalised over the years, the cooperative/po became the likely agent for its continued role as crop collector and risk aggregator due to the relatively small size of EU farms (about one-tenth that of the average US farm), their limited on-farm storage (Mathie, 2010), and over a century of legal certainty (France). The cooperative/po thus became responsible for storage and inputs and also arranged sales outlets for farmers. The most recent CAP reform Regulation issued in December 2013 reaffirms its commitment to Member State support for producer organisations. 4 However, the CAP has been progressively moving towards greater market orientation. This market orientation was strengthened in the latest CAP reform that formally started with the European Commission's Communication on Common Agricultural Policy (CAP) towards 2020, issued in November In the Communication s section 6.1. on market measures, the European Commission (EC) listed the well-functioning transmission of market signals as one of the key issues to be pursued and made a reference to the functioning of the agricultural commodity derivatives markets. Note that especially agricultural futures and options exchanges are important agricultural commodity derivatives markets that signal prices to the agricultural markets and are functioning well when they reflect the reality of agricultural production, demand and supply, and (international) trade. The ongoing liberalisation and market orientation of EU agricultural markets have been expected to lead to fluctuations in agricultural prices. The EC Communication s Section 4 identified rising price volatility as one of the challenges that the CAP reform had to meet. Also at the international level, such as the G20, increased food price volatility was considered a problem that had to be confronted. 6 In July 2010, the EP s Resolution on the future of Common Agricultural Policy after had already identified increasing market price volatility as a challenge and called for instruments designed to help reduce volatility and provide stable conditions for agricultural business and planning, including innovative economic and financial tools such as futures markets...as a way of dealing with extreme market or climate conditions without disturbing any private schemes that are being developed (Paragraph 80). Futures markets are indeed also tools for the management of the risk of agricultural price volatility, as is explained below in Section 1.3. of this study Commission Regulation (EU) No 1272/2009 of 11 December 2009 laying down common detailed rules for the implementation of Council Regulation (EC) No 1234/2007 as regards buying-in and selling of agricultural products under public intervention, Title 1, Chapter 1, Article 1. Regulation (EU) No 1305/2013 on support for rural development by the European Agricultural Fund for Rural Development (EAFRD) of 17 December 2013, Art. 27. Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions - The CAP towards 2020: Meeting the food, natural resources and territorial challenges of the future, COM(2010) 672 final, 18 November For more information, see Section of this study. European Parliament resolution of 8 July 2010 on the future of the Common Agricultural Policy after 2013, (2009/2236(INI)). 22

27 Financial instruments and legal frameworks of derivatives markets in EU agriculture Following the CAP legislative package presented by the European Commission in October , the reformed CAP included a risk management toolkit as one of the EU s priorities for rural development, namely promoting risk management in agriculture (the second pillar of the CAP, financed by the European Agricultural Fund for Rural Development (EAFRD)). However, no specific measures related to agricultural derivatives markets can be found in the CAP reform proposals. In order to deal more effectively with farmers income uncertainties and market volatility, risk management is dealt with by providing financial contributions for (a) insurance against economic losses to farmers caused by adverse climatic events and animal or plant diseases, for instance; (b) mutual funds that pay financial compensation for economic losses; and (c) an income stabilisation tool that supports mutual funds and compensates farmers in case of serious income losses. 9 In practice, since CAP reforms have continuously liberalised agricultural markets over the years and increasingly exposed the entire agricultural supply chain to price volatility, the cooperatives and producer organisations had to adapt to a new situation. In Western Europe, where price risk management tends to be integrated with the cooperative/po system, cooperatives have consolidated across regions, with several becoming transnational. They have also integrated their upstream and downstream operations through subsidiarisation (Filippi, 2012). Different types of profit-sharing arrangements are available, reflecting the cooperative structure of marketing. 10 There is a lack of statistics, however, on how many producers or cooperatives/pos use these contracts. These structural changes reflect adaptations to a more volatile price environment following the decoupling of price supports from specific commodities, while being shaped by historical, cultural and legal precedents. There are also spot contracts ( forwards ) in the EU that include fixed-price contracts, average-price contracts and basis contracts. In Eastern Europe, a lingering distrust of collectivism has meant that very few cooperatives exist. Market fragmentation, asymmetrical pricing between producers and buyers, and a lack of institutional support tend to impede producer price realisation (Garcia Azcarate, 2014). Producers grain tends to be sold at harvest, often at distressed prices, meaning that in many regions of Eastern Europe, farmers lack pricing power and are isolated from marketing channels that aid in the transmission of price along the supply chain. Thus, price risk management in the EU varies considerably among states and across regions, with the differences most pronounced between Western and Eastern Europe. In addition to the adaptations mentioned above, Western European cooperatives and producer organisations have increasingly sought price risk management for their farmer members via over-the-counter (OTC) instruments that guarantee a particular price for their products in the future. These OTC agricultural commodity derivatives (referred to as swaps 11 in the US) are contracts negotiated between large grain firms, brokers or banks called swap dealers and cooperatives/pos. Swap dealers may or may not themselves hedge the risks in their OTC contracts via equivalent futures in the exchange-traded markets. Grain firms that offer pure financial OTC risk management tools to farmers may in turn buy the underlying physical goods. OTC derivatives tend to be opaque, and as long as they remain unregulated (see EU reforms in the next chapters), the quantity of contracts For the different parts of the legislative package, see: OJ L 347, , p : Regulation (EU) No 1305/2013, Art For a list of spot market contracts available within the marketing chain, see: Habert, 2011:

28 Policy Department B: Structural and Cohesion Policies being concluded, their prices and their riskiness are unknown. Also unknown is whether farmers as members of cooperatives are fully advised on the details of these contracts, including price formulae and fee structures. Although agricultural regulations in the EU and the US continue to be harmonised in an ongoing process due to pressures from negotiations and agreements made within the World Trade Organisation, the goal of increasing farmers reliance on price risk management may not be suitable to the EU marketing system, which is quite distinct from the US. Indeed, in contrast to the EU, US farms are large with unequalled levels of on-farm storage (over 300 million metric tonnes in total according to USDA estimates). They therefore tend to make decisions on risk management or crop sales autonomously, having had many decades of experience using agricultural exchanges. The new US Farm Bill will reinforce risk management tools in order to deal more effectively with income uncertainties and market volatility. In this context of increasing market reliance, agricultural price volatility and competition with US farmers who use derivatives as risk instruments, increasing transparency and wellfunctioning agricultural commodity derivatives markets in the EU can complement CAP reforms. From 2010 to the new Commission was installed in 2014, the power at the EU level to initiate regulations on derivatives markets in general, including those pertaining to agriculture, lied with the Commissioner for Internal Market and Services. Commissioner Michel Barnier therefore initiated a range of financial sector reforms that have been coined the Barnier Package. The proposed reforms enabled the EU to deliver on its G20 commitments on reforming derivatives/swap markets, as will be explained in full in Section 3 of this study. In Section 2, the EU s financial reforms relating to agricultural derivatives markets are explained in detail. Following the reform of the derivatives markets, the issue has turned to which risk management mechanisms would form part of the CAP model as from 2017 (under a possible Mid-Term Review) or 2020 (after the end of the current Multiannual Financial Framework 2014/2020). In addition, broader reforms in agricultural policies at the local (national/european) and international/multilateral levels (WTO, G20) can mitigate the effects of commodity price volatility on farmers and consumers (see Section 4) Price risk management through futures markets: key elements Price risk management tools derive prices from the prices discovered by the derivatives traded on exchanges, as is the case with other advanced agricultural marketing systems. Among the derivatives traded on agricultural exchanges, futures are the most important for the hedging and price discovery functions of commodity exchanges. In the EU, only a small percentage of farmers use futures to manage risk. 12 Agricultural futures operate on the principle of convergence. Convergence is the process by which futures prices converge to the spot prices of the underlying good at the location where the underlying commodities are delivered, as designated in the futures contract s terms. Convergence works as a result of arbitrage, i.e. through traders buying and selling in different markets to profit from differences between futures and spot prices, during the contract expiration period. In countries with well-functioning futures markets, farm-gate prices are well correlated to futures. The difference between the farm-gate price and the There are many varieties of swap contracts. The CFTC defines a swap as any bilateral contract that is not an exchange-traded contract or a spot-market contract. Estimates vary between 3% and 10% of EU farmers. 24

29 Financial instruments and legal frameworks of derivatives markets in EU agriculture futures price is known as the basis (or base). The details of the derivative contract including the size of the contract, quality specifications, load-out terms and delivery points largely determine how relevant price discovery through exchanges is for the various actors along the supply chain. Transparency on prices is a primary determinant of price transmission and important for the convergence between futures and spot markets to work. EU spot prices are, to varying degrees, opaque, except in France, where the acceptance of milling wheat and maize futures as regional benchmarks has increased the transparency of spot and futures prices. At the farm level, price transparency is reportedly medium to poor for farmers among the various EU farming regions (Valluis, 2014a). There are several internet sites, however, that post futures price quotations as well as terminal spot grain prices delivered to the ports of La Pallice, Rouen or Port la Nouvelle in France. 13 Lack of streaming farm-gate prices i.e., data transmitted in real time over the internet is probably attributable to the cooperative/po structure which integrates farmers marketing and revenue distribution systems. The EU situation differs markedly from that of the US, where transparency along the entire supply chain has a long history. The US Department of Agriculture (USDA) and farm advisory services collect daily prices from hundreds of locations in all farming regions and make them available on the internet (previously radio). They keep farmers aware of important export information or policy developments. They also report prices when they diverge from previous basis levels. US farmers keep records of basis levels going back many years to help them with the timing of their sales. Although only about a third of US farmers use futures, they are extremely cognizant of futures prices. They also carefully record historical basis levels in different seasons and rely on their convergence-to-cash principle. The availability of multiple prices as well as farmers' access to delivery points greatly help farmers in achieving higher crop prices (Berg, 2008), especially since US farmers can access several competing bids on the websites of farm advisory services simply by submitting a postal code. Where markets and prices are opaque and fragmented, such as in Ukraine which is similar to eastern EU Member states, and in China and India the 1st and 2nd largest wheat producers - small farmers are captive to several intermediary mark-ups along the supply chain and remain bound to a persistently low level of income. 14 Another key element of the design of futures contracts are the delivery points, i.e., the location from which the commodity will be delivered once the physically settled futures contract expires. The distance between the delivery point and the place of production of the commodity will affect the price due to the costs of transporting the product to the delivery point. Globally, futures delivery systems vary widely, which can greatly affect their utility for producers. For example, the white and yellow maize contracts on the Johannesburg Stock Exchange allow for delivery across a broad production area, which includes 200 silos registered with the exchange. These contracts are used widely by South African producers for locking in prices in advance of harvest (Gravelet-Blondin, 2014) or alternatively as a marketing outlet for their grain. When the Maize Board was abolished in 1997, producers accustomed to delivering production to their local silo successfully lobbied to have the futures contracts include a broad geographical delivery area to accommodate producers' risk management as well as their logistical needs. By contrast, the London cocoa See: Renaissance Capital Agriculture, Economics of grain export trading, 12 May

30 Policy Department B: Structural and Cohesion Policies contract 15 features delivery points in store silos at various northern European ports such as Hamburg or Rotterdam. While this contract is useful for multinational cocoa processors, its utility for cocoa producers in Western Africa is questionable. In the EU, the NYSE Euronext contract specifies a public silo in Rouen (Fr) as a delivery point for milling wheat which, although simple to understand, may add to farmers basis risk if they are located far from this point. Unlike South Africa, where deliveries across the country are announced publicly and are available for bidding, the Rouen delivery point tends to give an advantage to export operations. Moreover, having just one delivery point means that information on futures prices are not disseminated down to farmers. For this reason, the exchange has added Dunkerque (Northern France) as an additional delivery point effective September As for the NYSE Euronext maize contract, the futures contract s function is undermined by its restriction to delivery at Atlantic ports, which is inconvenient for distant parts of the supply chain, particularly in Eastern European countries. Hungary 17 is landlocked and gets discounted prices accordingly (Habert, 2011), although it has tried to develop derivatives markets since it produces twice as much as its landlocked neighbour, Czechoslovakia. Prices tend to be higher when countries have coastal access, such as Bulgaria and Romania which have access to the Black Sea export market. In other words, geography matters greatly with regard to price realisation. Overall, trade sources estimate that producer price realisation by EU farmers might be around 75-80% of the futures price due to transport costs and intermediary margins (Valluis, 2014b). In the US, there is also an array of farm advisory groups to help producers map out the various sales strategies and pricing options available to them. Since exchange-traded options were introduced in the 1980s, farmers have grown increasingly sophisticated in the use of options as derivatives instruments in addition to futures trading. Because option buyers pay only an upfront premium for the right to establish a futures position, they are not subject to collateral, or margin calls as are the grantors (sellers) of these options rights. In 1993, the USDA launched an options pilot programme (OPP) that gave farmers the funds to buy 'put options' in lieu of deficiency payments. Although the OPP was not renewed in the succeeding farm bill, options' trading has since soared and farmers are reportedly making great use of them by entering the futures markets directly or having them embedded into spot contracts, such as minimum price contracts (MPCs). The US Commodity Futures Trading Commission (CFTC) provides a weekly overview of the trading activities of different players on the commodity exchanges. Prior to 2000, apart from the operations of a few commodity hedge funds, trade in agricultural derivatives was conducted between commercial hedgers entities such as large multinational grain firms, regional warehouses and a small percentage of producers and a community of local speculators. Since the turn of the century, however, the derivatives trading landscape has clearly become more complex, transforming itself into an international electronic arena encompassing many actors (see below). In sum, the challenge for policymakers trying to encourage price risk management among EU agricultural producers through futures markets will be to take into account the current realities of market structure shaped by the institutional, cultural and legal evolution of European agricultural markets while developing the means for bringing transparency to multiple layers of market activities and pricing Cocoa and sugar futures contracts are listed on NYSE Euronext. NYSE Liffe, Milling wheat futures and options contracts listing of new delivery months, 8 July 2013, https://derivatives.euronext.com/sites/derivatives.euronext.com/files/mo pdf (viewed 2 July 2014). The use of the exchange of Hungary is very limited. 26

31 Financial instruments and legal frameworks of derivatives markets in EU agriculture 1.3 Current landscape of agricultural derivatives markets There are approximately twenty major commodity derivatives exchanges around the world on which various agricultural derivatives are traded. The main EU exchanges are in Paris (milling wheat, corn, barley, rapeseed, skimmed milk) and London (feed wheat, sugar, coffee, cocoa), belonging respectively to Euronext and ICE. The major exchanges are in the US, which belong to the Chicago Mercantile Exchange (CME). By any standard, the growth in derivatives markets has been spectacular. Trading volumes in agricultural futures contracts at the CME more than quadrupled over the last 10 years. Figure 1: Trading volumes in agricultural futures contracts at the CME ( ) This growth can be largely attributed to the US trend towards deregulation throughout the 2000s, the liberalisation of global markets, and advancements in technology, including electronic trading and increasingly sophisticated proprietary algorithmic trading systems. These factors have transformed commodity derivatives markets from fairly insular centres where risk was transferred from commercial hedgers to a small community of local speculators into financial supermarkets that attract portfolio managers, index-tracking funds, pension funds, proprietary trading desks of banks and multi-billion-dollar hedge funds. When the food crisis hit in 2007/2008 and commodity futures prices and volumes soared, derivatives markets came into sharp focus especially among global regulators. 27

32 Policy Department B: Structural and Cohesion Policies In 2007/2008 and again in 2010, soaring US wheat futures prices diverged significantly from spot market prices. 18 Contending that futures had become too volatile and disassociated from the real market, some banks refused to lend to US farmers who had to pay high levels of collateral ( margin calls ) on their wheat futures due to the risks of volatile prices. Consequently, many farmers had to buy back their hedges, i.e. their short derivatives contracts, at enormous losses. In Europe, where agricultural commodity futures trading was relatively new and no regulatory framework or purposeful supervision of commodity derivatives markets existed, the crisis in soaring food prices made it painfully clear that more transparency and supervision were needed for these markets Securities and managed funds active agricultural derivatives markets The mid-2000s saw the growing trend toward the securitisation of futures instruments in commodity investment products. One such product is the 'commodity index fund' as offered in the US, which buys and sells commodity futures in order to replicate the performance of a commodity price index. Standard and Poor s Goldman Sachs Commodity Index (S&P GSCI), which tracks the prices of 24 commodity futures contracts (called a basket ) of which 14.4 per cent are agricultural (Vander Stichele and Van Tilburg, 2011: 18), is one of the most well-known commodity indices. Other types of commodity investment funds are commodity index exchange-traded funds' (ETFs), whose return is based on indices and whose shares are sold to investors. 'Exchange-traded notes' (ETNs) are unsecured debt obligations sold on exchanges. ETFs and ETNs are categorised as exchange traded products (ETPs). Figure 2: Evolution of global commodity ETP assets under management ( ): non-gold ETPs vs gold ETPs Source: ETF, Global Commodity ETP Quarterly Trends in the global commodity exchange traded products markets, July 2014, p. 5: figures up to 30 June For description of this issue, see: United States Senate, Permanent Subcommittee on Investigations (USS/PSI), Excessive Speculation in the Wheat Market, Washington, D.C., 24 June 2009, p

33 Financial instruments and legal frameworks of derivatives markets in EU agriculture In the US, there are several ETFs and ETNs based purely on agricultural commodity futures, of which the PowerShares DB Agricultural Fund (listed by Deutsche Bank on the US exchange NYSE Arca) is the largest (total net assets of $1,406,572,583 as of 30 June ). 19 An ETF fund manager in the US may purchase the futures of the (agricultural) commodities in the index, and roll these positions forward prior to contract maturity. In the EU, commodity index ETFs are synthetic, as they are not allowed to invest directly in (agricultural) commodity derivatives nor track an index with a single commodity (see section 2.2.7: UCITS IV law). US and EU fund managers may seek a swap with a bank to perform the management function or to ensure a return that equals the index. This swap counter party may directly buy commodity futures on exchanges. Following ten years of growth, a drop in commodity prices caused the level of investment in commodity index funds and exchange-traded funds to decline from a peak of $460 billion in notional value in April to $299 billion in as of January , slightly increasing by end of May 2014 to $311.4 billion notional value 22. 'Hedge funds' called alternative investment funds' in EU legislation and categorised as 'managed money' by the CFTC in the US, including Commodity Trading Advisors (CTAs) and Commodity Pool Operators solicit investors funds and trade aggressively on the futures markets, in both the US and the EU. Hedge fund activities in the US are monitored exclusively by the CFTC. In the EU, it is only since July 2011 that hedge funds have begun to be regulated and monitored (see section 2.2.5). The lack of EU regulation and supervision became evident in July 2010 when a single commodity hedge fund was able to corner the NYSE Euronext cocoa market, causing prices to spike higher and then collapse following the July contract expiration (Berg, 2013: 66-68). Some hedge funds often employ totally automated systems using algorithms and may engage in 'high-frequency trading' (HFT), which has come under scrutiny for its possible price-destabilising effects 23 and manipulation. Similar to index funds and exchange-traded funds, the hedge fund sector generated losses since 2012 according to industry analysts. From 2013 onwards, the managed (or hedge) fund industry has come under CFTC scrutiny for its opaque fee structure which allegedly consumes up to 89% of profits generated (Evans, 2013). Pure agricultural hedge fund statistics are difficult to come by because exchanges do not report them separately and because the majority of funds are multisector (Vander Stichele, 2012), combining several agricultural products, energy commodities and metals as underlying values. Moreover, in the EU, public reporting by hedge funds is minimal. CFTC figures reported by AMIS as managed money give some guidance (see Figure 3) Updated information about the PowerShares DB Agricultural Fund can be found on: (viewed 2 July 2014). CFTC, Index Investment Data, (viewed 21 April 2014): equals $255.8 billion net long notional value. CFTC, Index Investment Data, (viewed 21 April 2014): equals $176.6 billion net long notional value. CFTC, Index Investment Data, (viewed 1 July 2014): equals $182.2 billion net long notional value. Office of Financial Research, Annual Report 2013, U.S. Department of the Treasury, p , 2013_Accessible.pdf (viewed 8 February 2014). 29

34 Policy Department B: Structural and Cohesion Policies Figure 3: CFTC Commitment of Traders (May 2013-May 2014) Major Categories Net Length as % of Open Interest** Source: AMIS, Market Monitor, No. 19 June 2014, ** Disaggregated Futures Only Over-the-counter (OTC) derivatives Transactions in OTC commodity derivatives have also grown over the last 10 years. An OTC derivative is a bi-lateral financial transaction normally involving an exchange of payment flows between two counterparties for a particular quantity during a particular timeframe with reference to a specific price. OTC derivatives can be options, swaps, and other derivatives, called in general swaps in the US. The agricultural OTC swaps market in the US is small. 24 In the EU, however, OTC transactions appear to be a growing class of risk management tools offered by major grain firms, banks and brokerage houses to agricultural cooperatives. Volumes and pricing structures are opaque and will remain so until the EU requires trade repositories to publish their OTC trades (see also Section ) Bank participation in futures markets Banks both US and foreign have traded heavily in US futures markets having various roles: Large investment banks have been directly involved by operating a proprietary derivatives trading desk or hedging their swaps provisions (but have been restricted in the US by new regulations). Banks (along with broker dealers) provide OTC swaps to agricultural commercial players. Banks can operate large brokerages for futures. Banks are the primary issuers of exchange traded commodity products (ETPs) for which they earn a management fee. 24 In 2014, the CFTC lists do not report on (outstanding notional amounts of) agricultural swaps, (viewed 2 July 2014). 30

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